As global markets crater and central bankers from Washington to Tokyo scramble, where is China?
Asia's biggest economy has been remarkably quiet as echoes of the 2008 Lehman shock ricochet through bourses everywhere. World leaders from U.S. President Donald Trump to Japanese Prime Minster Shinzo Abe took to the airwaves to counsel calm. Yet from President Xi Jinping's team in Beijing -- just the sound of crickets.
While no one knows what is in Xi's mind, let us hope the mini-crash of the past week is catalyzing his team to step up the deleveraging and cleanup of shadow banking activities that are imperiling China's financial system.
As Wall Street looks for culprits for the recent chaos, much of the focus is on shadowy investment products tied to volatility. Lacking any clear fundamental explanations, investors are scrambling to read about how algorithms and high-frequency quantitative trading programs can suddenly make the Dow Jones Industrial Average trade like bitcoin. Loads of retirees are googling an index called the "VIX" at the center of a popular tactic to short volatility.
China was also puzzled in early 2016 as sudden drops in Shanghai shares shook global markets. Autopsies among traders then focused on a shadow banking system too big for regulators to comprehend or control. That led to stepped-up efforts to rein in one of China's riskiest investments -- so-called wealth management products, or WMPs, which are uninsured, high-yielding financial instruments sold by banks. Some progress has since been made.
A major profit center for mainland banks in recent years was buying these wealth management tools from each other. Regulators pounced, though, and in 2017 managed to more than halve such interbank holdings, which stood at about $520 million as of December. That reduced a threat that critics long worried was an accident waiting to happen. The problem: Banks used cheap and murky financing to bet on other institutions' higher-yielding products. When market demand goes away, the reversal of those trades can reverberate far and wide, catching more conventional markets terribly unaware -- as happened in China in 2016.
The bad news is that the broader outstanding WMP balance continued to rise apace in 2017. Despite increased scrutiny, overall issuance rose 3%. As Fitch put it in a Feb. 6 report, there is both progress and backsliding here. On the one hand, Fitch said Beijing "authorities have had some success in reining in associated contagion and liquidity risks." But it added, "the resilience of overall issuance underscores our view that it will be difficult for the authorities to reduce" this important segment of shadow banking activity.
Difficult because WMPs account for nearly 17.5% of bank deposits and roughly 40% of those at so-called joint stock banks, which are formed by groups of businesses. The labyrinth extends from there. WMPs are linked to government and quasi-government debt, repayment promises of financial institutions and companies, and non-standard credit assets, meaning investments that are not traded. In other words, Fitch warned, "a more aggressive crackdown would have the potential to disrupt financial markets and trigger disorderly deleveraging."
This leaves Xi with a daunting balancing act. China's $16 trillion shadow banking industry is simultaneously too big to fail, too big to save and, increasingly, too pivotal to the economy to disappear. WMPs are a particularly delicate challenge. At the end of 2017, they accounted for more than $4 trillion, or 36% of gross domestic product. Xi must impose order and sobriety in an especially murky part of China's financial system that is almost the size of Japan's annual output without killing growth.
Yet Wall Street's wild swings increase the urgency of the task.
The eerie calm among Beijing officials despite the market jolts is the result of a comparatively closed capital account, a firmly managed currency and skillful liquidity management by the People's Bank of China. Chen Long of Gavekal Dragonomics calls the central bank's cagy success in raising interest rates while maintaining decent liquidity the "secret ingredient for financial stability." Beijing also is stealthily adding to its foreign currency stockpile. It rose for the 12th straight month in January to $3.16 trillion.
But the lopsidedness of the economy and excessive control explain why China is not really part of the global conversation. It has neither contributed to the beatings that markets are taking, nor is it viewed as a solution or safe haven. China's capital markets punch below their weight despite the country's fast-growing geopolitical importance because financial development is not keeping pace with Xi's ambitions.
This power paradox is due more to Beijing's shadow banking monster than Communist Party bigwigs like to admit. It is a daily reminder that for all the rapid economic growth, the ambitions of the Belt and Road Initiative and Asian Infrastructure Investment Bank, the scope of China's territorial land grab and Xi's big talk about China's readiness to lead, the economy stands on shaky foundations. As Japan learned the hard way, strength begins -- and is sustained -- at home.
Xi must empower regulators to add teeth to deleveraging efforts. Ironically, the stronger Xi and his party become and the bigger the ambitions, the greater the odds of unproductive credit creation. "One risk of tightened party control in the banking sector is the potential for distorted lending activity by encouraging banks to extend credit to politically favored causes such as the Belt and Road Initiative," said Michael Hirson of Eurasia Group.
Because most WMPs remain as off-balance sheet assets, they draw comparisons to Western lenders' exposures during the subprime crisis. Last year, China included these vehicles in its periodic health checks for lenders, part of a crackdown on excessive debt and financial risk. It is a terribly complicated issue and one that can intersect with Beijing's anti-corruption push. In November, regulators handed down a record fine to China Minsheng Banking Corp. for trafficking in fake products.
But lax internal controls are too rampant even in legal circles to tame this monster. Containment efforts must give way to bold steps to slash China's reliance on shadowy finance and get serious about deleveraging. If Xi drags out this must-needed reckoning, today's calm will be followed by a proverbial storm.
William Pesek is a Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades." He has written for Bloomberg and Barron's.